Economic Overview

The euro zone, which comprises more than half of the nations in the EU, ranks as the largest economy with a GDP of $18.45 trillion in 2011. Being a services-oriented economy, services account for a whopping 70% of its GDP!

On top of that, the eurozone takes pride in being the second most attractive investment market for domestic and international investors.

As an economic union, the euro zone has a standardized system of laws, particularly for trade. The size of their entire economy makes the euro zone a major player in the international trade arena.

Because the individual countries are grouped as one entity, it enables them to facilitate trade easier, mostly with its number one trade partner, the U.S.

This active participation in international trade also has a significant impact on the role of the EUR as a reserve currency.

This is because countries who transact with the euro zone need to have a significant amount of reserve currencies in order to reduce exchange rate risk and minimize transaction costs.

Monetary & Fiscal Policy

The European Central Bank (ECB) acts as the governing body for the monetary policy of the EU. Led by the current ECB President Mario Andretti… errr, we mean Mario Draghi, the Executive Board also consists of the ECB Vice President and four other policymakers.

Along with the top guns from the national central banks within the euro zone, they make up the ECB Governing Council who vote on monetary policy changes.

The main objective of the ECB is to maintain price stability in the entire region – quite a tall order! To achieve this goal, the eurozone signed the Maastricht Treaty which applied a certain set of criteria for the member nations. Here are some of the requirements:

The nation’s inflation rate must not exceed the average inflation of the three best performing (lowest inflation rates) states by more than 1.5%.

Their long-term interest rates must not exceed the average rates of these low-inflation states by more than 2%.

Exchange rates must stay within the range of the exchange rate mechanism for at least a couple of years.

Their government deficit must be less than 3% of their GDP.

If a nation fails to meet these conditions, they are penalized with a hefty fine. Yikes!

The ECB also makes use of their minimum bid rate and open market operations as their monetary policy tools. The ECB minimum bid rate or repo rate is the rate of return the central bank offers to the central banks of its member states. They make use of this rate to control inflation.

Open market operations, on the other hand, are used to manage interest rates, control liquidity, and establish monetary policy stance. Such operations are conducted through buying or selling of government securities in the market.

In order to increase liquidity, the ECB buys securities and pays with euros, which then get circulated. Conversely, to mop up excess liquidity, the ECB sells securities in exchange for euros.

Conversely, to mop up excess liquidity, the ECB sells securities in exchange for euros.

Other than making use of those monetary policy tools, the ECB can also opt to intervene in the foreign exchange market to further cap inflation. Because of this, traders pay close attention to comments from the Governing Council members since these could impact the EUR.

Because of this, traders pay close attention to comments from the Governing Council members since these could impact the EUR.

Getting to Know the euro

Aside from being dubbed the anti-dollar, the euro is also nicknamed “fiber.” Some say that this nickname was derived from the Trans-Atlantic

Some say that this nickname was derived from the Trans-Atlantic fiber optic, which was used for communication, while some argue that it was from the paper used to print European banknotes way back then! Here are some of the other characteristics of the euro.

Here are some of the other characteristics of the euro.

They call me the Anti-Dollar!

With the euro popularly known as the anti-dollar, EUR/USD is the most actively traded currency pair. As such, it is also the most liquid of the major pairs and offers the lowest pip spread.

I’m busy during the London session…

The euro is most active during 8:00 am GMT, at the beginning of the London session. It often has little movement during the latter half of the U.S. session, around 5:00 pm GMT.

…and I’ve had a few relationships.

EUR/USD is often linked to the movement of capital markets, such as bonds and equities. It is negatively correlated to the movement of the S&P 500, which represents the performance of the U.S. stock market.

This correlation was thrown out of sync after the 2007 financial crisis though. Now, EUR/USD has a slightly positive correlation with the S&P 500.

EUR/USD is also negatively correlated to USD/CHF, reflecting how the Swiss Franc moves in almost perfect tandem with the euro.

Important Economic Indicators for the euro

Gross Domestic Product – Gross domestic product is the central measure of economic growth in the region. Since Germany is the largest economy in the euro zone, its GDP tends to move the euro the most.

Employment Change – The euro is also sensitive to changes in employment, particularly in the euro zone’s largest economies like Germany and France.

German Industrial Production – This measures the change in volume of output from Germany’s manufacturing, mining, and quarrying industries. Because of this, it reflects the short-term strength of German industrial activity.

German IFO Business Climate Survey – This is one of the country’s key business surveys. Conducted monthly, this takes into the account the current business situation of Germany as well as expectations for future conditions.

Budget Deficits – Recall that one of the criterias in the Maastricht Treaty requires that euro zone economies keep their debt-to-GDP ratio below 60% and their deficit less than 3% of its annual GDP.

Failure to achieve these targets could result to fiscal instability in the euro zone.

Consumer Price Index – Since one of the goals of the ECB is to maintain price stability, they keep an eye on inflation indicators such as the CPI.

If the annual CPI deviates from the central bank target, the ECB could make use of its monetary policy tools to keep inflation in check.

What Moves the EUR?

Eurozone Fundamentals

Reports of strong economic performance by the euro zone as a whole, or by its member nations, can boost the euro higher. For instance, better than expected GDP reports from Germany or France could encourage traders to be bullish on the euro.

Uncle Sam’s Groovy Moves

Sudden changes in market sentiment, buoyed mostly by U.S. economic data, tend to have a huge impact on EUR/USD.

Being considered the anti-dollar, the euro is also swayed by talks of reserve diversification away from the U.S. dollar. Euro as the new reserve currency, anyone?

Differences in Rates of Return

Bond spread between 10-year U.S. government bonds and 10-year Bunds (German bonds) usually indicate the direction of EUR/USD.

If the difference between the yields of the U.S. bonds and Bunds widens, EUR/USD moves in favor of the currency with the higher yield.

Similar to bond yields, interest rate differentials also serve as an excellent indicator for the EUR/USD movement. For instance, traders usually compare the Euribor futures rate with the Eurodollar futures rate.

Just to clear things up: “Euribor” is an acronym that stands for Euro interbank offer rate, which is the rate Euro zone banks use for inter-bank transactions, while Eurodollars are deposits denominated in U.S. dollars.

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